The passage of the Dodd Frank Act, the Market Abuse Directive (MAD) and MiFID, as well as the newly issued Guideline 2012/122 from the European Securities and Markets Authority (ESMA), which covers algorithmic and direct market access (DMA) electronic trading, is clear evidence that the regulation of financial markets continues to go through unprecedented rate of change.
The pace of regulatory change is not only unprecedented – it’s speeding up. In December 2011, ESMA issued an initial set of guidelines around algorithmic and direct market access electronic trading. The final requirements, Guideline 2012/122 or “Systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities,” were released in February 2012 and came into force on May 1.
Guideline 2012/122 is significant. It covers both client and proprietary trading and affects firms engaged in purely with proprietary trading as well as those offering DMA, who now need to surveil and report on trading activities performed by their DMA clients.
The timeframe gives regulators, market places and market participants only a few months to implement changes to pre-trade systems, order management systems, surveillance and monitoring systems, and internal organizations and processes – a very tall order.
If we take a moment from the rush to comply with all of this, we can identify a few trends, both among the rules and regulations and in the greater market, that help predict where the markets might be heading and what firms will need from their market surveillance and supervision systems.
Trends in Regulations
· Surveillance on order level. Market abuse is increasingly done at order level, where actors seek to gain a market advantage by creating a false picture of price movement and/or liquidity through various strategies.
Spoofing and layering are very good examples, and the £8M fine issued by the UK’s Financial Services Authority in 2011 is a prime example how important it is to safeguard your firm and identify suspected cases as soon as possible. This will help ensure that appropriate actions can be taken before you make headlines in the press.
· Real time. Regulators are increasingly expecting trading platform and market participants to be able to very quickly act and report on observed potential market abuse and suspicious orders. The ESMA Guideline explicitly states near real time, although ESMA does not currently provide an exact definition what that means. It is clear, however, that the trend is moving towards intraday detection, with appropriate actions being taken and reporting to the competent authority on the day of trading.
· Cover all orders and trades flows that are electronically sent to a trading platform. This includes order flow routed via DMA, where under ESMA, market participants will have to monitor client order and trade flows for potential erroneous transactions and market abuse and report any suspicious orders and trades.
· Flexibility and ease of change. ESMA’s Guideline includes a list of explicit market abuse cases that a surveillance solution should be capable of detecting. This trend of explicitly demanding that surveillance solutions be able to monitor for certain behaviors will likely continue. It is therefore important that systems can easily change and introduce new alerts and reports.
Closely tied to this is the ability to fine tune alerts to watch the market at an appropriate level. Surveillance officers also need to focus their efforts on investigating relevant suspected cases of abuse rather than trawling through false positives. Both the technology and the role of people are an ongoing effort and parameters need to be adjusted continuously, as market volatility and behaviors naturally change over time.
Volumes and Market Evolution
The volume of messages that needs to be processed by a surveillance and supervision system is ever increasing. The move to automated trading applications and the introduction of High Frequency Trading (HFT) strategies will continue to push up volumes.
Proposed rules and regulatory changes will limit or slow down the rate of increasing order rates, but there is no doubt that the high volumes we see today are here to stay and will continue to increase. That means that regulators, trading venues and market participants will have to implement organisations, processes and surveillance and monitoring systems that can cope with these vast message volumes and accurately pinpoint suspicious trading.
More Asset Classes
The MAD and MiFID reviews share Dodd Frank’s objective to ensure orderly and fair OTC markets. The proposed introduction of Organized Trading Facilities (OTFs) and Central Counterparty Clearing (CCP) obligations on OTC trading – and the inclusion of trading done on an OTF under MAD – means that your surveillance and monitoring organization will need to be able to manage and analyze these new asset classes and market models.
Cross-Asset Classes
Regulators are starting to look at market abuse across linked products, such as front running on a derivative when you have a client order on the underlying, or moving the price on a commodity while holding a very large futures position. Your surveillance solution will need to monitor for these patterns and be configurable to search across different asset classes as market structures evolve.
Cross-Market and Cross-Borders
Trading is moving to cross-market places and cross-borders. In order to get a complete picture of trading patterns and order books, your solution must be able to monitor the same instrument traded at several venues and detect patters across these.
Surveillance and monitoring are a key focus for anyone that wishes to remain competitive in the financial markets. Organizations need flexible and agile processes and tools to keep up with the rate of change that we are expecting over the next several years.
There are also opportunities for the organizations that are willing to look holistically at how they monitor all of their market activities. The more demanding regulations are actually an opportunity to get a clear and concise view trading across asset classes and markets, reducing financial and regulatory risk across the board. Surely this is a good thing for everyone?
By Magnus Almqvist, SunGard’s Protegent business unit